Market breadth – the number of stocks rising or falling within a benchmark – is one of the most important indicators for portfolio strategy. Changes in market breadth can determine the relative success of both active-versus-passive and value-versus-growth investing strategies.
Right now, the market breadth of the S&P/TSX Composite Index is narrowing. As a result, indexing and large cap, growth-oriented stock selection strategies are likely to produce better returns.
The chart below shows the relative performance of two different benchmarks for the TSX: The widely-followed S&P/TSX Composite Index, which is market cap weighted – larger companies have a bigger effect on performance; and the equal weighted S&P/TSX benchmark, where each stock's moves affects the index equally. On the chart, both benchmarks are indexed to 100 as of October, 2011 (when the equal weighted index began).
The widening lead of the cap weighted benchmark over the equal weighted one signals that market breadth is narrowing – in other words, positive performance is increasingly limited to fewer large cap companies, while smaller ones appear to be languishing. The trend also suggests that earnings growth is becoming more scarce. If profit growth were widespread, small and mid cap companies would drive the equal weighted benchmark higher.
S&P/TSX Equal Weighted index vs S&P/TSX Composite
SOURCE: Scott Barlow/Bloomberg
Growth investing strategies work better in periods when profit growth is harder to find. Investors gravitate towards the (relatively smaller) number of stocks showing earnings growth, pushing those stock prices (and their price earnings ratios) upwards.
Value investors in this environment often get caught in the dreaded “value traps.” The term describes stocks trading at attractive (ie. cheap) valuation levels but where the stock price fails to appreciate because the profit outlook either worsens or stagnates. Teck Resources could be an example of a value trap. It continues to trade at a price that is low relative to the value of the commodities it produces.
A continually narrowing domestic market will see the current performance leaders – the financials – move higher and become more expensive while other sectors languish. Passive, index-based investing strategies will outperform. The large cap financials will drive the index higher while bargain hunting active investors get stuck in value traps. Admittedly, this isn’t the easiest investment concept to fully grasp – it certainly took me a long time. In the end, it’s merely an outgrowth of one of investing’s prime directives: The best returns come from buying the largest stream of earnings at the cheapest possible price. When profit growth becomes scarce, it costs more in terms of valuation levels.
Scott Barlow